The New Fed
See you later, credit allocator.
“Things are seldom what they seem.” –W.S. Gilbert, “H.M.S. Pinafore”
Nowhere is this more true than in government – which means we have to watch it closely. Unfortunately preconceived notions can make us impervious to events right in front of us and lead us to colossal misperceptions.
Take the Federal Reserve System. (All together now: Please!) Since the central bank controls the money supply, advocates of free markets and market-based money are understandably wary of its power to generate inflation. It’s inflated in the past and has the capacity to do so in the future. So attention naturally goes in that direction.
The problem is that while we’re watching for inflation, we might be missing the Fed’s real mischief elsewhere. In stage magic this is called misdirection.
Jeffrey Rogers Hummel, a macroeconomist at San Jose State University and a Freeman contributor (not to mention an old friend), says that’s exactly what has been happening. While inflation hawks have been busy looking for any sign, or even any word, of monetary expansion, Hummel writes, “[Fed chairman Ben] Bernanke has so expanded the Fed’s discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner.”
In other words, “Bernanke’s targeted and sterilized bailouts have altered the fundamental nature of the Federal Reserve…. [T]he Fed that emerged from the [housing and financial] crisis is no longer the same as the Fed before the crisis…. Most economists appear not to appreciate fully how drastic the changes are that Bernanke has wrought.”
Key Word
Note the key word “sterilized.” That means the Fed’s huge bailout program has been carried on largely without creating net new money. And that makes the Fed a menace to markets even when it’s not generating inflation! Hummel says that what we should be concerned about today with respect to the Fed is not inflation but central, nonmarket control of the allocation of scarce capital. In our obsession with inflation, we are missing an ominous leap further into corporate statism.
Hummel spells this all out with admirable clarity and detail in “Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner,” published in Robert Higgs’s great quarterly journal, The Independent Review, Spring 2011.
Bernanke’s efforts to channel capital to particular firms and sectors, including insolvent financial institutions, are breathtaking in scope. Previous Fed chairmen, notably Alan Greenspan, poured new money into the economy in response to anticipated crises, but they did not attempt to direct the money to chosen destinations. That was left to the market (however distorted). Things are different now. Bernanke directs the flow of credit – and has been doing it generally without creating new money.
How so? By selling assets to or borrowing money from banks and others institutions. Follow the money: When the Fed sells assets (T-bills, mortgage-backed securities, whatever) or borrows, it takes money out of the economy. If it turns around and lends the money to a bank, the impact on the money stock is a wash. However, the Fed has acted like a central planner of the capital market.
Hummel leaves no doubt what the Fed was up to before September 2008:
Bernanke was not injecting liquidity, just redirecting it…. Bernanke was pulling money out of the economy by selling Treasury securities…. [H]is aversion to inflation left little room for a genuine liquidity injection…. Its [the Fed’s] borrowings would simply pull money out of the economy on one end of its balance sheet, and then it would put that money back in on the other end through loans to favored firms and purchases of favored instruments.
Quantitative Easings?
After that the Fed appeared to create huge amounts of new money, through what has been called “quantitative easing” (QE1 and then QE2). But since 2008 it has also paid banks interest on reserves kept in their Fed accounts. “Bernanke in effect created money and then borrowed it back from the banks by paying them interest…. [T]he payment of interest on reserves was tantamount to borrowing back from depositories the full $800 billion increase in reserves and more. No wonder the impact of the base explosion on the broader monetary measures (except for M1) was so muted,” Hummel writes.
Summing up, Hummel says, “Helicopter Ben talks a good line about being ready to unleash quantitative easing, but this talk only imparts an aura of justification for the Fed’s incredibly expanded role in allocating the country’s scarce supply of savings. If anything, his policies were closer to a quantitative tightening. A better moniker would therefore be ‘Bailout Ben.’”
Counterintuitive, I know. See the article for supporting material. We may ask: Will we face a bad inflation when those interest-earning bank reserves now sitting in Fed accounts are finally released into the economy? Not if the money is removed first. This is not as unlikely as it may seen. Hummel reminds us that Greenspan three times dramatically pumped up the money supply in response to perceived crises: Black Monday on October, 19, 1987; Y2K; and 9/11. “Whether necessary or not, all three interventions constituted sudden, general injections of base money into the financial system that were just as quickly unwound,” Hummel writes (emphasis added). Not only is hyperinflation not necessarily around the corner, but there would be little payoff to the government in any event. (See why here and in briefer form here.)
Needless to say, acquitting Bernanke of inflationary policies is not equivalent to giving him high marks. Far from it: “In the final analysis, central banking has become the new central planning,” Hummel writes. That’s an alarming development indeed. As Hummel said elsewhere, “[D]enying that the Fed is likely to generate much inflation because of current institutional, structural, or political constraints no more implies that the Fed is harmless than denying that the FDA causes inflation implies that the FDA is harmless.”
Comment by bionic mosquito on 29 July 2011:
“We may ask: Will we face a bad inflation when those interest-earning bank reserves now sitting in Fed accounts are finally released into the economy? Not if the money is removed first. This is not as unlikely as it may seen.”
It is very unlikely. Without this injection, the banks are insolvent. They are insolvent because many of the assets they hold are not generating cash and are therefore not worth the mark-to-fantasy values at which they are held.
In other words, there are no excess reserves in truth; they are only excess because of the false accounting.
Additionally, how will the Fed unwind? Who will buy the rotten assets that the Fed took on its books? The Fed took these at what is almost certainly face value (or close to face value) – far above the worth at the time or at any time today or in the future. Who would pay face value to buy these from the Fed? If the Fed sold them all, they will recover only a fraction of the money that was injected when the Fed first bought or swapped for the assets.
There is no way the injection by the Fed is reversed.
Pingback by The Old Fed was bad enough…. | The Locker Room on 29 July 2011:
[...] {"data_track_clickback":true};var addthis_options = "facebook,twitter,email,favorites,print,"In his Freeman column today, Sheldon Richman writes about the powers that Ben Bernanke now has, enabling the Fed not just [...]
Comment by Deefburger on 29 July 2011:
How much of the Fed’s asset holdings are physical commodities like precious metals, how much is paper commodities, like land buildings and machinery, and how much is paper obligations like loan paper, and how much is paper paper, like FRNs? Any FRNs and obligations are worthless in a crisis. FRNs are worthless to the Fed itself.
Comment by James Ahiakpor on 29 July 2011:
I understand that Sheldon Richman bases his piece on the New Fed on Jeffrey Hummel’s 2011 article. But having accepted and made his points here, I think Sheldon could be asked to account for what I believe are two inaccuracies. First, we are asked to believe that the Fed has not crearted any “new money” with its recent (at least summer 2008) monetary actions. From Series H.6 of the Federal Reserve data, I find that M1 (narrow definition of money, seasonally adjusted) stood at 1419.9 billion in July 2008, rose to 1661.5 billion by July 2009, up to 1726 by July 2010 and up to 1947.4 by June 2011. Thus, between July 2008, M1 increased by 37.2 percent. Meanwhile, currency in circulation stood at 775.6 billion in July 2008, rose to 855.4 by July 2009, up to 888 billion by July 2010, and up to 965.1 billion by June 2011. That is, currency in circulation increased by 24.4 percent between July 2008 and June 2011. So how can one say that the Fed did not create “new money”? Clearly, the Fed didn’t borrow all of its newly created monetary base back, did it? I was stunned when BEn Bernanke, in his December 2010 CBS interview with Scott Paley, denied that the Fed wasn’t creating new money with QE2. I don’t think Bernanke was correct.
Second point, although the Fed does influence mainly the currency component of the money supply (M1 or M2), I don’t think it is correct to say that the Fed “controls” the money supply or money stock. The banks, through their lending policies, and the non-bank public, thorugh their currency-deposit preferences, also do influence the money supply.
Comment by Charlie on 30 July 2011:
One question that I think is as important as any other….why did they stop counting M3? That’s the real tell-tale of economic strength.
Hmm…maybe I just answered my own question. Any other thoughts?
Comment by Sheldon Richman on 31 July 2011:
James, I said “largely without creating new money,” a point that should be clear throughout the piece. As for the monetary growth that has occurred, Jeff Hummel comments:
“[C]urrency in circulation increased 24 percent over three years under Bernanke, which is about 7.5 percent annually, the same annual growth rate for currency over Greenspan’s nineteen years at the Fed.
“Moreover, during the period from August 2007 to September 2008, when Bernanke was engaging in sterilization, the growth rate of currency did temporarily fall to nearly zero. By focusing on the subsequent increase in currency, that part of the base that was growing the slowest, with much of it flowing abroad, James would seem to be reinforcing our claim that paying interest on reserves neutralized the many-times larger increase in reserves.”
Hummel adds that neither he nor I “impl[ied] that the Fed tightly controlled the money stock. Indeed, if anything the opposite. And doesn’t this point cut against James’s citing the growth of
M1 as contradicting your statements about Fed policy?”
Comment by Sheldon Richman on 31 July 2011:
I’ve asked Jeff Hummel to respond to the earlier comments also.
Re bionic mosquito:
“The first point made in this comment is both internally contradictory and irrelevant. Banks can only increase the money stock beyond the monetary base if they start making loans. But if the banks are truly insolvent in the sense implied, then they obviously are not able to do so. Only if they are solvent enough to make loans will the Fed need to reduce excess reserves in order to prevent inflation.
“The point is irrelevant because an alternative way the Fed can offset a bank expansion, only hinted at in the post, is by increasing the interest rate it pays on reserves. This will give the banks an incentive not to make loans, plus solving any real or imaginary solvency problems.
“The comment’s last point is mistaken for two reasons. First, of the Fed’s current $2.9 trillion balance sheet, $1.6 trillion consists of Treasury securities. Remember, that QE2 consisted mainly of purchasing long-term Treasuries. So unless the U.S. government defaults, the Fed can unload more than half of its portfolio quite easily.
“At the moment the Fed is holding slightly less than $1 trillion of mortgage-backed securities and federal agency issues. That is down nearly $300 billion from its peak in mid-2010. The reason it is down is not because the Fed is selling them but because they are maturing. And on net, the Fed is earning money on them, not losing money. Some of these assets were toxic but not all of them, and the losses have proved to be far smaller than the temporary, panic-driven decline in their value during the
financial crisis seemed to suggest.”
Re Deefburger:
Federal Reserve notes are never, ever Fed assets. They are Fed liabilities. He can go to the H.4.1 Release to see the
precise breakdown of all the assets. Beyond the two categories I mention below, the largest item on the balance sheet is foreign securities of over $100 billion. Fed bank premises are valued at only $2.2 billion and the gold at $11 billion (although as we know on the market it is worth much more). The rest is mostly miscellaneous types of loans.
Comment by James Ahiakpor on 31 July 2011:
I recognize that this is not the forum for engaging in discussion that may be considered technical. (I should read Jeff Hummel’s article and take up a detailed dispute with his analysis in that journal.) But Sheldon’s and Jeff’s responses so far appear to miss the point I raised. I don’t think the data confirm their claim that “the Fed’s huge bailout program has been carried on largely without creating new money” nor that “Bernanke was not injecting liquidity.” It was to address the period of the “Fed’s huge bailout program” that I chose the data from July 2008. In fact, if we moved back to July 2007, M1 stood at 1370.7 billion, indicating a 42 percent growth in that measure of “money” by June 2011 when is reached 1947.4 billion. Currency in circulation (my preferred measure) also stood at 758.7 billion in July 2007 and increased by 27 percent when it reached 965.1 billion by June 2011. Surely, the public did not create the additional 206.4 billion of currency (“liquidity”) in circulation by itself. The Fed did.
On the other hand, the monetary base increased by 222 percent from 821,830 billion in July 2007 to 2,647,237 billion by June 2011. The reason that phenomenal increase in the base has not resulted in the rate of inflation some may have expected is that most of it has been held in reserves at the Fed. As David Hume long explained in his essay, “Of Money,” only the currency in circulation affects prices: “It is also evident, that the prices do not so much depend on the absolute quantity of commodities and that of money, which are in a nation, as on that of the commodities, which come or may come to market, and of the money which circulates. If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.”
We can clarify the failure of price inflation to explode in the U.S. but without denying the obvious that the Fed has increased the money supply or “liquidity” since engaging in its “huge bailout program.”
Comment by James Ahiakpor on 1 August 2011:
I wrote that the monetary base rose from 821,830 billion in July 2007 to 2,647,237 billion in June 2011. I should have written million, not billion. The data are from the Federal Reserves series H.3 denominated in millions, not billions. The percentage change remains at 222 percent over the period.
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